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Deflation is here. The question before the house: How long it will last?

Ideally, it's just passing through, albeit throwing everyone into a temporary tizzy with worries that the U.S. is set to repeat the Japanese experience. Certainly the Federal Reserve is working overtime trying to make sure the disease is short-lived. But for the moment, at least, prices are generally falling, as we've discussed, including here.

The great experiment in trying to keep a sustained case of deflation at bay is upon us. The immediate danger is that consumers and businesses expect deflation to persist. As many studies have shown over the years, along with more than a fair bit of empirical evidence, expectations are critical factors in determining the level of inflation and its cousin, deflation. Once the Fed loses the battle on managing expectations, monetary policy becomes much weaker.

On that note, we must recognize that one measure of expectations, in the form of market prices for expected inflation, is clearly flashing a warning signal. Expected inflation for the next 10 years, based on the spread between nominal and inflation-indexed 10-year Treasuries, was a mere 0.13%, as of December 26, 2008. That's down from nearly 2.6% in July, as our chart below shows.

click to enlarge

The collapse in inflation expectations is hardly surprising, given what's been going on in recent months and the related descent of interest rates. It would be a miracle if inflation expectations hadn't fallen sharply in the current climate.

From an investment perspective, one might wonder how to think of TIPS vs. conventional Treasuries these days. We can start by recognizing that most of the collapse in inflation expectations is due to the fall in yields on conventional Treasuries. TIPS yields have fallen too, but not nearly as much. The result, as our second chart below reveals, is that something close to parity now prevails for nominal and real (inflation-indexed) yields on Treasuries.

Normally, conventional Treasuries yield more than their inflation-indexed brethren. Why? The extra yield is compensation for exposing one's investment to the ravages of future inflation, if any. Conventional Treasuries only guarantee a nominal yield; TIPS only guarantee an inflation-adjusted yield.

Expecting some level of inflation is the normal state of affairs. Inflation, in the long run, usually dominates, thus the yield premium in conventional Treasuries. But these aren't normal times and so the yield premium for standard Treasuries has shrunk to almost nothing compared with TIPS. And rightly so, if we accept that deflation is the bigger risk at the moment.

In any case, real and nominal yields on 10-year Treasuries are roughly comparable. Buying either security means that you're locking in a yield for the next 10 years of slightly above 2%.

If you expect inflation to one day return, as I do, buying the 10-year TIPS is a no-brainer, since you currently don't have to accept a lower yield relative to conventional Treasuries and at the same time you receive an inflation hedge, effectively at no extra cost. But while running the printing presses at full steam implies that inflation will one day return, perhaps with a vengeance, we can't be absolutely sure about timing or even if higher inflation is fate. We believe it is, but, hey, the future's never fully clear. Meanwhile, some investors and traders are betting that deflation will run on for some time, perhaps longer than expected, and perhaps even for the next 10 years.

Pick your future — and your poison. We don't know which strategy will work out best, but we're supremely confident that one side of this coin will suffer badly. Alternatively, you could hedge the future with a passive allocation to Treasuries and buy an equal mix of nominal and inflation-indexed 10-year Treasuries.

If nothing else, at least we know this: investment choices are just as tough in times of crisis as they are when bull markets are everywhere.

Source: Welcome to Parity